Houston Corporation is considering an investment in equipment for $45,000.Data related to the investment are as follows: Cost of capital is 18 percent.
Houston uses the straight-line method of depreciation with no mid-year convention.In addition, their tax rate is 40 percent, and the life of the equipment is five years with no salvage value.
What is the net present value of the investment?

Question

Houston Corporation is considering an investment in equipment for $45,000.Data related to the investment are as follows:  Cost of capital is 18 percent.
Houston uses the straight-line method of depreciation with no mid-year convention.In addition, their tax rate is 40 percent, and the life of the equipment is five years with no salvage value.
What is the net present value of the investment?

Quizplus · Accepted Answer

1. Calculate the annual depreciation expense: 
Annual depreciation expense = (Cost of equipment - Salvage value) / Life of equipment 
Annual depreciation expense = ($45,000 - $0) / 5 
Annual depreciation expense = $9,000

2. Calculate the annual net cash flow: 
Annual net cash flow = Annual after-tax cash inflow - Annual depreciation expense 
Annual net cash flow = ($21,600 x (1 - 0.4)) - $9,000 
Annual net cash flow = $9,360

3. Calculate the present value of the annual net cash flow:

Year | Annual net cash flow | PV factor (18%, n) | PV of net cash flow 
1 | $9,360 | 0.8475 | $7,925.20 
2 | $9,360 | 0.7185 | $6,724.56 
3 | $9,360 | 0.6084 | $5,699.74 
4 | $9,360 | 0.5155 | $4,829.08 
5 | $9,360 | 0.4374 | $4,088.06

PV of net cash flow = $28,266.64

4. Calculate the initial investment as a negative cash flow: 
Initial investment = -$45,000

5. Calculate the net present value: 
Net present value = PV of net cash flow - Initial investment 
Net present value = $28,266.64 - $45,000 
Net present value = -$16,733.36

Since the net present value is negative, Houston Corporation should not make the investment. Therefore, the best choice is B, which is the net present value of the investment (-$16,733.36).

Houston Corporation Is Considering an Investment in Equipment for $45,000